How to Make a Decision about Mergers and Acquisitions

How to Make a Decision about Mergers and Acquisitions

Article excerpt

Outlines the steps to be taken for making a decision about merger and acquisition ... generating realistic forecasts of demand, price and revenue are very critical... combination of revenue growth and cost reduction are needed for a successful merger and acquisition.

Accurate and realistic revenue forecasts are critical to the successful outcome of mergers and acquisitions. Most business combinations fail to achieve their promised payoff in terms of growth and profitability, yet it is revenue that heavily influences the long-term outcome of a merger.

By applying a more systematic approach to analyzing the demand and pricing assumptions of potential targets during the due diligence process, companies can identify potential "red flags" and improve acquisition decisions.

The causes of value-destroying acquisitions are frequently traced to a number of factors. These include offering a sizeable premium, overestimation of cost savings and synergies, and poor postmerger integration. One inescapable conclusion, though, is that revenue growth is a key driver of successful merger and acquisition outcomes.

As such, generating accurate and realistic demand, price, and revenue forecasts are equally critical factors of success. Improving the chances of success requires the integration of a number of forecasting tools, processes, and skill sets that are not commonly hard wired into merger analysis.

REVENUE GROWTH: A POWERFUL LEVER

Companies' reasons for acquiring the assets of another company are generally rooted in sound strategy - to expand geographic market access, merge complementary product portfolios, vertically or horizontally integrate into new high growth or low cost technologies and market segments. Strategic and accounting rule considerations aside, analysis of the financial benefits of deals often quickly focuses on near-term earnings performance (e.g., "will this deal be accretive to earnings per share? If yes, by how much and when?"). This focus on earnings impact also leads to estimates of potential cost savings and/or restructuring related "synergies" that promise to enhance the profitability of the deal to the acquiring company.

A danger in the approach that focuses heavily on the short-term earnings impact is that it may obscure the fact that postmerger revenue growth, not cost structure alone, is a crucial factor underlying value creation. Fluctuations in revenue - a function of demand and price - may actually hit the bottom line more directly. As Figure 1 shows, the combination of revenue growth and cost reduction are often needed to achieve a break-even earnings-per-share (EPS) impact. For example, a one-percent decline in revenue in this scenario (driven by price or volume) requires a 26% increase in planned cost savings to achieve a breakeven EPS deal. Likewise, beating revenue forecasts by a few percentage points can offset a significant shortfall in realized cost savings.

In light of the potential impact of revenue forecasting errors, it is interesting to note that many due diligence checklists and financial models lack a rigorous or detailed approach to evaluating top line growth and market drivers. In the IBF Fall 2002 benchmarking issue, one year out aggregate forecasting error (percent error) of 11% was reported across survey participants for all industry categories. Percent error of 21 % was reported at the product/service category level. The implications are clear. Companies are challenged sufficiently to forecast their own demand and revenue. Doing the same for a potential acquisition target with limited information is a serious challenge.

Merger plans that miss on the revenue side can have a direct impact on the earnings results - even in the short term. The results can be damaging; the market can and does severely penalize an acquiring company's share price for a moderate shortfall against EPS guidance. Consequently, a "vicious" cycle can ensue. …